Shares of Duolingo (DUOL -1.05%) fell about 13% on Friday, Nov. 11 after the company posted a third-quarter earnings report that most companies can only dream of. In a nutshell, the company's language-learning application is more popular than ever and converting millions of free users into paid subscribers.
In these troubling economic times, investors want to see profits and that was something that Duolingo couldn't deliver. While I generally prefer buying businesses that are already making money to those that report losses, Duolingo's latest report showed several signals that suggest its bottom line can soon explode into positive territory. Here are three of the most important ones.
1. Approaching profitability
During the third quarter, Duolingo reported a net loss of $18.4 million on a GAAP basis. If we adjust for non-recurring charges the company actually earned $2.1 million before interest, taxes, depreciation, and amortization (EBITDA).
An easy way to evaluate the execution of a high-growth company's business plan is by comparing gross profits from the most recent reporting period to operating expenses in the previous year period. The $69.7 million gross profit that Duolingo reported in the third quarter was 53% higher than it reported a year earlier. Total operating expenses rose just 21% over the same time frame. If this trend continues the company could begin reporting sustainable operating profits in 2023.
2. Converting like crazy
The number of monthly active users on the Duolingo application rose 35% year over year, which is impressive on its own. The stock is a screaming buy right now because the number of paid subscribers rose almost twice as fast.
Paid subscriptions rose 68% year over year to 3.7 million at the end of September thanks to relentless testing of new lessons and gamification techniques. Duolingo doesn't just talk a good game when it comes to the importance of A-B testing. It has numbers that prove it's on the right track. Subscription penetration has more than doubled since early 2020 to 7.4% of monthly active users.
3. Beyond languages
Duolingo cut its teeth on languages but many of the lessons it's learned so far apply to education in general. With this in mind, the company launched Duolingo ABC in 2020 to help young learners overcome basic literacy challenges.
In October, Duolingo took a big step out of its language-learning wheelhouse and launched a math-based application for elementary-school-aged children and adults who get nervous if someone asks them to calculate the tip at a restaurant. It's too early to gauge Duolingo Math's popularity but investors want to keep an eye on this space.
4. English instruction will drive growth
Duolingo recently published a study that shows Spanish learners of English who completed Duolingo's basic coursework later scored much better than expected on a commonly used U.S. English proficiency test.
If you're reading this without the help of translation you probably don't realize how much demand exists for English language instruction. As the primary language for business communications and scientific research, students and professionals seeking better opportunities the world over must budget for English language instruction.
When the COVID-19 pandemic forced businesses of all stripes to reevaluate remote work, it opened a lot of doors for non-native English speakers who want Western-sized salaries without having to leave home. This is a big part of the reason market research provider, The Brainy Insights expects global spending on English language learning to grow from $11.4 billion last year to $35.8 billion in 2030.
In addition to helping students learn English, the company's English proficiency test is quickly becoming the global standard. The Duolingo English Test is already accepted by 3,800 higher education programs. Revenue from the test, which is administered online reached $8.2 million in the third quarter and will soon be a larger contributor to the top line than advertising.
At recent prices, you can buy Duolingo stock for just 8.7 times trailing twelve-month sales. That is a very reasonable price to pay for a fast-growing business that is rapidly approaching profitability.